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Fallen Angels And Draghi’s Steinhoff Demons

It is not unusual that losses may be happening. All other central banks that ran similar programmes – do we know whether they had losses? No, because they are not disclosing the issuers, the holdings… We are much, much more transparent. We have a risk framework which has served very very well since beginning of the existence of the ECB, and if we need to draw lessons, we will certainly draw lessons.

That’s what Mario Draghi said on Thursday when defending the ECB amid questions about whether Steinhoff’s recent trials and tribulations underscore the inherent danger in the central bank’s corporate bond buying program.

To be sure, these concerns are hardly confined to CSPP. If we learned anything from the eurozone debt crisis it’s that sovereign debt isn’t “risk free” either, but it would be obtuse to suggest that imperiled corporate debt doesn’t add a new dimension to the equation.

Here’s what I meant when I said “trials and tribulations” above:

Obviously, that raises all kinds of questions not only for the ECB’s position in Steinhoff’s debt, but for CSPP as a whole.

“I cannot elaborate a lot about what we are going to do next,” Draghi said yesterday, in response to questions about how the central bank was planning to deal with the Steinhoff debacle.

He was pressed further: “So just to follow-up to that answer on the Steinhoff debt; is the consideration at the moment about selling your holding of the debt?”

“That’s what I meant when I said that I cannot elaborate more when I answered before,” Draghi retorted.

Ok, so think about this in the context of an issue we’ve raised on any number of occasions over the past several months. Namely this: if CSPP is effectively preventing idiosyncratic risk from manifesting itself in credit spreads, what happens when the program is tapered? We addressed this most recently in “An Oxymoron For 2018.” Here’s a short excerpt from that post:

The question here is clearly this: will idiosyncratic risks be magnified as global QE is rolled back? Or, zooming in on Europe, is CSPP keeping idiosyncratic risk from manifesting itself in wider spreads for problem sectors?

The Steinhoff situation raises a related question: what happens if the ECB becomes an active seller?

First of all, here’s a chart from BofAML that shows how spreads have evolved on the ECB’s corporate holdings since they first showed up in the portfolio (in other words, what looks like a line here is actually just a collection of 1,059 dots):

So yeah – the Steinhoff situation is an outlier to say the least. Still, BofAML notes that “by par amount, IG downgrades continue to outpace upgrades, and the ratio has actually deteriorated this year [and further] credit markets globally have been experiencing negative ratings migration of late.” Here are the charts on those two points:

The bank goes on to ask the obvious question: “How much of a problem will this be for Draghi?” Here’s the answer – or at least part of an answer:

Using S&P’s historical rating transition matrices, we estimate that €7bn of corporate bonds that the ECB own will end up as Fallen Angels prior to maturity (by bonds impacted, this is equivalent to €38bn of total outstanding debt).

The bottom line here is that although Chart 8 suggests the pain for fallen angels has been less acute over the last ten years, that trend might not hold if the ECB were to itself become an active seller.

“Credit investors should therefore anticipate more pronounced price drops in names that migrate from IG to HY next year,” BofAML warns, before concluding that “there may now be a big buyer (ECB) behind some of these credits that chooses to become a seller upon downgrade.”

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice